IRS Section 1031 Exchange Basics
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Since we’re getting into tax season, I’m getting more calls over the last few days regarding the basics of a 1031 delayed or reverse exchange so I thought it best to review some of the most important aspects of a 1031.
This allows investors to use all of the sale proceeds to leverage into more valuable real estate, increase cash flow, diversify into other properties, reduce management or consolidate holdings. And notice that I wrote “all of the sales proceeds”. If that rule is not followed, then you would have to pay ‘boot’ on the proceeds taken out of the 1031. This isn’t tax fraud, but does seem to invite an audit.
I get a number of question regarding what type of property qualifies for a §1031 tax deferred exchange. The Internal Revenue Code Section 1031 states that “no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.” “Like-kind” property can include, but is not limited to, any of the following, provided it is held for investment:
- Single Family Home Used as a Rental
- Duplex
- Apartment
- Commercial Property
- Undeveloped Land
For example, raw land can be exchanged for a single family rental, or apartments or a commercial building. Properties can be exchanged anywhere within the United States.
Another question I get from sellers new to this process is “does the 1031 exchange need to simultaneous”? No, contrary to what some property owners envision, a §1031 tax deferred exchange is rarely a simultaneous two-party swap. In fact, I’ve never done one. Most exchanges are delayed exchanges, whereby the Exchanger has 180 days between the sale of the relinquished property and the closing of the replacement property. They must identify the potential replacement property (or properties) within 45 calendar days from closing on the relinquished property.
When can you use section 1031 exchange? It is applicable whenever a property owner intends to sell any property that is not their primary residence, and falls under the definition of “like-kind” and plans to BUY another ‘like-kind’ ‘replacement’ property within 180 calendar days following the closing of the relinquished property.
Paramount to any exchange is a competent and experienced Qualified Intermediary. A few intermediaries filed for bankruptcy during the last crash and left the exchanger contractually obligated to complete the purchase plus they owed the capital gains taxes and without the funds held by the bankrupted intermediary. I sure there are bigger disasters that one can encounter, but that’s up there.
